Last week Bloomberg writer Zeke Faux’s piece on Death Spiral Financing allowed a small chink of light to shine on the Private Issuance market. Death spiral structures are not new, and generally appear to be above board, but it is hard not to recognise the risk and damage they pose to investors in a company that chooses to source finance in such a manner. Private transactions tend to be by their nature private. They tend to be structured between (one hopes) sophisticated parties that are able to shoulder the burden of reduced disclosure and consequent increased risk. One wonders though what consideration is given to other stakeholders? Smaller shareholders, employees, customers, suppliers to mention a few.

In the Public Issuance market recent reporting by the Financial Times offers insight into the activities which may occur during the book building process. While activities such as order inflation may be known, the allegations made regarding fake order creation to win more paper, will shock many.

It seems clear that Control Functions should review their organisations’ issuance procedures, with careful attention given to where business lines meet, such as at Syndicate and in the Private market, where transactions are handled together between banking and markets. These areas represent gap risk, as consideration may have been given to each business individually, but not together as a whole.

Press reports of the deal Standard and Poors have reached with Federal and State Agencies shines a light on the challenge faced within the Financial Industry to bring about cultural change. Paul Barrett writing for Bloomberg describes one of the defences S&P’s lawyers used early in the case, making the blunt observation: “The company said that its claims to objectivity and independence were “mere puffery,” the sort of marketing blarney that sophisticated investors don’t believe.”

We commonly encounter nuances of this through our work supporting Internal Audit. We find it is a sentiment, or culture, that is deeply ingrained in the DNA of Front Office Staff. “Everyone knows how the market works”, “They are all Big Boys”, are all precursors to the push-back levelled at Internal Audit that control staff do not understand how the market works, and the points being raised are not points at all. By challenging these assertions we help Control Staff bring about effective change. Skadi Limited’s Consultants are all experienced Front Office practitioners. All have been Traders, Capital Markets, Research and Inter-Dealer Broking professionals. We help Control Staff identify where Front Office behaviour falls short, placing the institution and its staff at risk.

Regulation is presently undergoing a sea change. Many activities within the Financial Industry have been guided by etiquette rather than rigorous rule structure. Whether this continues remains to be seen, but we would all do well to review how etiquette is defined: “The customary code of polite behaviour in society or among members of a particular profession or group.” Adhering to this sentiment would do much to render the “Big Boy Defence” obsolete.

As the dust settles from thursday’s shock move by the Swiss National bank, news is beginning to emerge of the impact the Franc’s appreciation has had. As Product Controllers and Market Risk Managers get to grips with traders’ exposures, and whether internal risk limits and stress tests have proved adequate, they would do well to consider wider areas of exposure. We take this opportunity to highlight potential areas of risk which warrant consideration. We have been warning that FX along with Funding represent two areas where scope remains for traders to take significant risk in their trading books. Owing to the pooled nature of currency booking which still exists at many Financial Institutions, and the fact that FX booking systems often stand alone from the primary booking engine for many businesses there is wide scope for error and abuse. We recommend Control Staff turn their attention to verifying that derivative structures have been booked correctly. Quantos booked as Composites and vice versa represent a significant area of risk. Rehedging within Legacy Businesses is a cause for concern as staff with responsibility for managing portfolio wind downs may not be aware of the need for currency rehedging through the life cycle of structures – last week’s move will make this apparent. Counterparty credit will be recognised since a number of brokerages have already failed, however staff must now consider the impact on derivative contracts which had seemingly benign payoffs, as well as the exposure of Mortgage customers who have been sold out of currency products offering yield advantage though Swiss Franc borrowing. Legal and Compliance as a priority should review how these products were solicited, marketed along side the supporting documentation.

On Monday, the Russian Central Bank took bold action, raising interest rates by the most in 16 years. Elsewhere around the Emerging Markets risk premia rose, with a knock on effect to volatility. Interest Rate rises of this kind were witnessed in 1997 and 1998 when Central Banks’ sole objectives were stabilising currencies. What gives us grave concern is that Trader Funding Risk remains, in our eyes, a risk for many banks.

Historically Financial Controllers were responsible for ensuring adequate funding was in place to support traders’ market positions. The responsibility for Cash Management, to give Trader Funding Risk another name, has gradually been handed over to the people trading the underlying assets. Positions resulting from structured trading generally have specific term structures. Funding Risk related to these activities is relatively transparent. Market-making positions and certain proprietary strategies have less certain holding periods and therefore the funding required to support them is of varying term.

Within banks there appears to be little line of sight over the specific Funding Risk traders take. At the macro level Treasury Departments can generally see whether a business is funded, they may be able to see the term, but they cannot relate that to the Market Risk the traders are running and whether it is appropriate. This is because Market Risk is the remit of Market Risk Management. Market Risk limits are generally transparent and well understood. The expectation is that Funding Risk traders take will relate directly to the Market Risk they are running. The assumption is that a limit structure for controlling Funding Risk would be unnecessary. Trader Funding Risk therefore is in danger of falling between the two controls.

A further layer of complexity is added by those businesses able to generate their own funding, either through synthetic trading or certain lending activities. Funding Risk generated in this way can be reflected in the Market Risk Report or the Business’ Funding Report depending on how the positions are booked out. This makes Funding Risk opaque, and indeed this may suit certain traders, particularly those that opt for internal arbitrage strategies, ie generating profits from their own bank’s weak accounting and control. The fact that some traders continue to exploit banks’ internal systems for their own benefit, rather than highlight failings to control functions, reflects the challenge facing banks that are attempting deep cultural change.

Juniorisation of trading teams since the 2008 crisis adds to the risk facing banks. Traders are now used to a long stable low interest rate environment. Traders who began trading in 2009 now have 5 years of experience under their belt, and will likely have significant confidence and trading limits. They have only traded in one interest rate environment and there is a risk that they are unaware of the potential pain sharp rises may cause.

Finally the move in interest rates heightens the risk of trader malfeasance, as traders facing losses in late December will face the temptation of hiding losses to protect bonus payments. With Funding Risk lying outside of the main booking system for many businesses there is double key entry risk, with trades not being booked in both systems, as well as place holder risk i.e. Traders manufacture positions through placeholders relying on large orphan cross bank positions to muddle the control functions.

Hopefully our concerns will not play out, but it would be prudent for Audit Managers to raise awareness within their teams.

The December BIS Quarterly review contains an interesting piece which analyses the performance since 2007 of the three main classes of banks – retail funded, wholesale funded and trading led.

Its broad conclusions are:

There has been a marked shift away from wholesale funding to retail funding, while the number of trading-led banks has remained constant.

Profitability of all three models has fallen sharply, but trading-led banks have suffered the most.

Trading-led banks have gone from the most profitable sector, with ROE approaching 20%, in 2007, to the least, with ROE of 5%, in 2013.

Trading-led banks have consistently had the highest cost-income ratios, at approximately 70% versus 60% for retail banks and 50% for those which fund mainly in the wholesale markets.

Trading-led banks carry significantly more capital, with a capital adequacy ratio of 17.3% versus 14.6% for retail banks and 12.2% for wholesale.

So, trading-led banks demand more capital, have significantly higher costs in relation to income, have suffered the most severe fall in profitability, are the least profitable and worst performing of the three groups. However, their numbers have not shrunk to reflect these factors, whereas the number of wholesale-funded banks – which have not performed as badly – has shrunk substantially.

The authors of the report surmise that the reason for this is that investment bankers pay themselves so well that they are loath to change their business model – they organise their banks for themselves, in other words, rather than their clients or shareholders. This may or may not be true – after all, past busts have been followed by booms, and banks which closed down or cut too deeply missed out – but the BIS’s view is undoubtedly the one that will gain traction.

This will inevitably provide more ammunition for the UK’s politicians and regulators to squeeze the investment banks. Already, they have taken powers for themselves to control what and how bankers are paid, and are imposing limitations on risk that will make it harder than ever for investment banks to produce worthwhile levels of profitability even if and when the good times return.

All this means that it is more vital than ever before that banks understand and control their risks (and risk takers), that costs are kept under control and that management is kept fully aware of any business or reputational threat before it blows up into yet another scandal. All in all, therefore, the role of internal audit has never been more important.

Mark Carney’s words in Singapore are enough to send a chill down the back of any senior manager in any bank. He said that the succession of scandals:

“mean it is simply untenable now to argue that the problem is one of a few bad apples. The issue is with the barrels in which they are stored”.

“Leaders and senior managers must be personally responsible for setting the cultural norms of their institutions. But in some parts of the financial sector, the link between seniority and accountability had become blurred and, in some cases, severed.”

Management is no longer just responsible for running the organisation for which he or she is responsible: they are also to be legally responsible for setting “the cultural norms” of that organisation. Accordingly, it won’t just be the culprit in any scandal who suffers, or the bank for which they work. Their managers, too, will be made personally to carry the can, whether or not they approved of, or even knew of, the activities concerned.

The erosion of the burden of proof is stunning. Already, managers will have to prove that their actions were not imprudent in any legal case resulting from the current regulatory deluge: under Carney’s Law, even that will not be enough, because now not having the correct (i.e. regulator-approved) “cultural norms” in place could in itself be enough to destroy the career and financial position of a manager.

The implications are wide-ranging, but this clearly puts an added burden on management and the audit function which supports it. In order to cover themselves, management will have to be assured that the products for which they are responsible are working not only within the letter of the regulations and the bank’s own controls, but also are following a culture of customer-care and honesty at all times and under all conditions. The problem, of course, is that culture can be defined differently by different people, so banks will have to impose standards of behaviour that go beyond the letter of the law.

It is hard to see how management and auditors will be able without properly qualified help to determine what standards should be followed, and what cultural norms should be established.

Clearly, therefore, there is a need for banks to take advantage of independent expertise: people with senior-level experience of the areas which will come under the most scrutiny, notably at the “sharp end” of investment banking, and with a profound understanding not just of how traders and other professionals work and even think – poachers turned gamekeepers, in other words.

At Skadi Limited we can offer exactly such expertise. With decades of experience in trading, analysis and management, we can “see” things that less experienced people will miss, helping audit to identify issues that need to be flagged and assisting in the process of presenting those findings on a equal footing to senior management.